Summary and Analysis

Banking

Central Banking System

Test

The money supply is defined as the total amount of currency plus deposits held
by the public.

Problem :

What are the three ways that the Fed can influence the money supply?

The first is through open market operations. The second is by changing the
reserve requirement. The third is through changing the federal funds
interest rate. Each of these actions in some way affects the total amount of
currency or deposits available to the public.

Problem :

How does the Fed affect the money supply through open market operations?

Open market operations are a form of monetary policy, meaning that the Fed
directly affects the money supply. Open market operations are the sale and
purchase of government bonds issued and regulated by the Fed. When the Fed
sells government bonds, the public exchanges currency for bonds, thus resulting
in a shrinking of the money supply. When the Fed purchases government bonds,
the Fed exchanges currency for bonds, thus resulting in an increase in the money
supply. Open market operations are the most common tool that the Fed uses to
affect the money supply. In fact, almost every weekday government bonds are
bought and sold in New York City.

Problem :

How does the Fed affect the money supply by changing the reserve requirement?

The second way that the Fed can influence the money supply is through changing
the reserve requirements. This is a form of fiscal policy because the Fed
is working with the finances of banks to affect the money supply rather than
with the money supply directly. We learned earler that the money
multiplier shows how
much an initial deposit increases the money supply after loans are made and
redeposited. Recall that the money multiplier is one over the reserve
requirement. Thus, if the reserve requirement is decreased, banks are required
to hold fewer reserves and can then make more loans. This in turn repeats the
cycle of loan to deposit, resulting in an increase in the money supply. For a
given initial deposit, a smaller reserve requirement will result in a larger
money multiplier, and thus in a larger change in the money supply.

Problem :

What are the four major safeguards in the US banking system?

There are a number of safeguards built into the US banking system. The first is
the Federal Deposit Insurance Corporation. The FDIC insures individual
deposits up to $100,000 in the case of a bank collapse. This measure is
supposed to inspire confidence in the public that the money it deposits in a
bank will not be lost, despite unforeseen events. A second safety measure is a
system of bank checks and audits by the government to ensure that prudent
banking practices are being observed. These are simply very detailed
examinations of bank records and dealings. The third safeguard is the regular
verification that banks' holdings meet reserve requirements. In this way, banks
are prepared to pay depositors as needed and may be able to avoid a bank
failure. The fourth safety measure is that banks are limited in the investments
that they may make with deposited funds. Banks not only earn money from
interest on loans, but they also invest money in bonds and stocks. By
regulating the amount of risk that a bank can undertake in its investments, the
government ensures that depositors' money will be relatively secure, even in the
case of poor economic conditions. In all, the government regulates the actions
of banks in such a way as to maintain the US banking system as one of the safest
and most open in the world.